A white paper produced by the Hedge Fund Operational Peer Group, a group of hedge fund CFOs and COOs and service providers, provides a blueprint for managers to think about when working with service providers.

The paper is entitled Service Provider Selection and Co-Sourcing: The Keys to Establishing a Cost Efficient and Institutional Quality Hedge Fund Infrastructure.

It includes a series of articles from a range of firms spanning legal, accounting, prime brokerage, compliance, administration, technology, the aim being to provide managers with a working solution for how to develop an institutional infrastructure in a cost-effective way.

One of the report’s lead editors is Marshall Terry, chief operating officer of New York-based credit fund South Ferry Capital Management.

“Managers need to think about how to handle today’s regulatory and investor demands in a pro-active way. That’s how this white paper started. South Ferry Capital Management LP launched in 2010 when the regulatory landscape was starting to look ominous. Investors were starting to ask for more so we moved quickly to create strong relationships with good service providers, a couple of whom appear in this white paper. It’s really a collective idea,” says Terry.

The key message underlining the report is that managers can create an institutional-quality infrastructure by creating relationships with the right service providers. It is a hard business to get into, the barriers to entry are higher, but it can be done.

“Managers keep hearing from the press, from panel discussions etc, they need to institutionalise their infrastructure for investors to take them seriously and invest. Okay, well what does that mean? We think this document addresses that question through all the buy-side and service provider folks who contributed to it. So far, the feedback has exceeded our expectations,” adds Frank Napolitani, managing director, prime services group at Concept Capital, one of the report’s authors.

All managers are likely to have primary relationships with legal, audit, administration and prime brokerage partners, but there is a raft of other operational demands to consider: IT, CRM, risk management, compliance.

Adds Napolitani: “You might not need all of these relationships in place from Day One but depending on who your investor base is you might need them soon thereafter so they should be factored in to a manager’s overall operating budget.”

What this paper is attempting to do is help managers strike a balance between forging what it refers to as “co-sourced” relationships – where a particular function is performed by a service provider and shadowed internally by the manager – and maintaining in-sourced functions.

“If you understand what needs to be solved then by building co-sourced relationships they become an extension of your firm. All we’re trying to say is ‘Yes, these regulatory realities are daunting but you can prepare for them’,” says Terry.

Every manager is different so deciding how far to go down the co-sourcing route will alternate. Napolitani says managers should “right size” their business for the current environment: “If you’re a USD20m start-up with three staff I would co-source as much of the operation as possible. If I’m USD250m aiming to get to USD1bn and I’ve got 10 employees I’d look at things slightly differently, maybe keep certain functions in-house but selectively choose which elements to co-source as well.”

The days of spending 10 years or longer gradually building out the operational infrastructure are over. Managers have to hit the ground running from day one. But this shouldn’t be met with despair or despondence. By using co-sourcing, today’s manager can develop a lean, cost-efficient institutional-quality infrastructure and not have to hire huge teams of support staff.

Administration and risk management are two important co-sourced relationships that South Ferry has built, says Terry, where strong policies and procedures have been established, underpinning each relationship. “For example, ConceptOne help with our daily risk reporting needs. That’ll help us get through Form PF and other regulatory hurdles going forward.

“Co-sourcing has helped us remain headcount-lean. Because technology is so good, and the fact that we’re shadowing everything day to day, it makes for a very efficient process.”

It is likely that some iteration of this model will be the future of how hedge funds are run with internal teams building tighter, more collaborative relationships with their service providers and reaping the benefits, not just of an institutionalised infrastructure, but greater transparency.

“This white paper aims to provide managers with a roadmap – here are some of the critical building blocks that you should consider for building out your infrastructure, and some of the issues that you should be thinking about,” adds Terry.